Why Covered Calls Often Use Short Term Options
Doc Maher answers UPod's questions.
THE PLAY - The Covered Call
To learn more about Covered Calls, please check out Play #6 of The Options Playbook located in TradeKing's Learning Center.
ALL-STAR COMMENTARY - by Doc Maher
UPod has been selling calls six months out for his covered call plays. UPod explained: "...the main reason I sell calls with a longer expiration is due to the higher premium that comes with a greater amount of time decay. I'd appreciate your thoughts / insight into this logic (especially if it's flawed)."
"Flawed" is probably not the right the way to look at it, I would say "not optimal." The covered call strategy tries to capture the time value of the option that you sell. So the quick answer you will usually get is that options time decay faster as they get closer to expiration. This is the reason that the more common way of setting up a covered call is to use the shortest time available. Exactly why is that important? Longer term options have a higher premium so isn't that better?
Although most practitioners of the covered call strategy understand this I want to explain in more detail why it is the preferred method.
To illustrate exactly how this trade off works out, I have constructed a couple of charts of Theoretical Option Prices versus Time. These are based on a $45 stock and the at-the-money option (ATM). The curves were created using the Black-Scholes model with the following parameters:
Stock price $45
Strike price $45
Risk Free Interest rate 3%
Implied Volatility 30%
All the parameters except for time remain constant, which simply means that the stock stays at $45 and the IV stays at 30, etc.
The first chart shows two options, one has 60 days to expiration and the other has 30 days. Most option players will be familiar with the shape of these.
Click here for a larger image.
This chart shows the "classic" time decay curves. The 30 day call starts with a premium of $1.60 and is worthless at the 30 day mark. The 60 day call starts with a premium of $2.29 and is worthless at the 60 day mark. So the 60 day option has a larger premium, $2.29 against $1.60. However in the first 30 days the 30 day option has decayed out the entire $1.60 while the 60 day option has only decayed out $0.69 to $1.60.
When you think about it this makes sense because at the 30 day mark, the 60 day call now has 30 days left. At this point it should be exactly the same price as the 30 day call when we started. And we can see that in the second 30 days the 60 day option is exactly the same as the 30 day option was after the first 30 days.
So if we write (sell) a 60 day call on this hypothetical $45 stock, we would collect $0.69 for the first 30 days and $1.60 for the second 30 days for a total of $2.29. If we had sold a 30 day call we would have collected $1.60 for the first 30 days, then sold another one for $1.60 and collected a total of $3.20 for the 60 days instead of only $2.29.
So what happens when we go out six months? The chart below shows a 185 day call versus a 30 day call under the same conditions as above.
Click here for a larger image.
As we can see the 30 day option decays from $1.60 to worthless in the first 30 days as before. However the six month call, which starts at $4.15, only decays $0.38 in the first 30 days to $3.77. According to this model we could write six of the 30 day options, each for $1.60, in the six months it takes for the six month call to lose its $4.15. That's 6 x $1.60 = $9.60 in premiums over six months versus $4.15 for the six month call.
So UPod here is your answer. To restate it, the short term options lose more time value over a given period than longer term options. This is why short term options are often used in the covered call trade.
I hope this helps clear things up.
"Income Trader"
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Nicole Wachs contributed to this blog.
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Please read Characteristics and Risks of Standardized Options.
While implied volatility represents the consensus of the marketplace as to the future level of stock price volatility or probability of reaching a specific price point there is no guarantee that this forecast will be correct.
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Jonathan F. Maher, PhD has a professional business relationship with TradeKing.
Edited by TK All-star at 10/07/08 at 03:20 PM
Comments
Follow commentsS90911 posted July 03, 2008 (07:11AM)
Excellent explanation. Although I knew the answer, seeing the proof in the charts made it easier to see why.spshapiro posted July 04, 2008 (03:25AM)
Although I can’t disagree with the theoretical analysis, and although I most often use shorter term covered calls, I do want to point out a couple of ‘real life’ facts.First, although it is necessary for the analysis to hold the price of the underlying security as a constant, it is never the case in the real world. When there is an appreciable change in the price of the underlying, it is possible to buy back the option for a good gain. Yes, there would be a gain in the shorter term option as well, but frequently the dollar amount earned in the shorter term would be so small, that the cost of the purchase becomes relevant. I have found that generally I don’t bother with trades which will net out at less than $100. In those cases, I usually would close to let the position expire, if it only had a month to run. I can’t tell you what your ‘price to get out of bed’ should be, but we all have one, so it is best to figure it out before you put the trade on.
Second, covered calls are painful when placed on stocks which are going through a downward spiral, but they are perfect for stocks that run in cycles. If you do a short term call which expires worthless in a month, when you attempt to place the next call, it will probably be at a lower strike, because of the lack of premium at the higher strike. When the stock finally recovers, you will be more likely to be exercised at a lower strike.
Third, because of that situation (cited above) and other contingencies, it is highly unlikely that you will ever sell six one month calls instead of one six month call. What I have found is that, if I’m good/lucky, I might sell three two/three month calls on an underlying stock in one year’s time.
redsoxrule posted July 06, 2008 (04:15AM)
Pretty simple and clear explanation
DannyUpshaw posted July 06, 2008 (08:02PM)
From my limited experience, the real key with selling short term covered calls is to find the "sweet spot" with time decay. You want to sell them for a decently high priced premium and have the option expire or become worthless as soon as possible. I think each stock has it's own sweet spot, but I've had the best luck trading Dell, who has strike prices at every dollar on the dollar. Generally, with Dell at least, selling a covered call about 10-15 days out (sometimes 7-8 days out) will get you a decent profit (assuming that you got in at a decent price) and a quick expiration on the option.
If you own a stock that's trending down, I like to sell the option about 30-45 days out and then buy it back for dirt cheap a few weeks later. You may lose some value on the stock, but if played right, you can pick up a decent profit on the call. Of course, you may have to wait for the stock to go back up, but as I've grown to be a better trader, I've *tried* to stop buying any stock that I wouldn't be ok going long on, so having to hold a while usually doesn't bother me. --doesn't warren buffet say something like, "don't own any stock that you wouldn't be happy owning for 10 years" ...?
DannyUpshaw posted July 06, 2008 (08:10PM)
As a quick follow up, I'll give an example of Dell. In the past, I've bought the stock about $23.00. Then, I rode the stock up to about $23.73 and sold a covered call for $70 that was about 10-12 days before expiration. I blogged about all this a while back, and if I remember correctly my option expired. So, if I had owned 500 shares of Dell, and sold 5 options, and they all expired, I would have profited about $350 in about 10-12 days. If the option had been executed, I would have made about $850 in 10-12 days. Worst case scenario, the stock tanks, I keep $350, and have to hold Dell until it goes up again, probably in a few months. --there's an extra advantage here too...the money that I made selling the covered calls would actually allow me to sell the underlying stock at a small loss, and STILL profit on the overall transaction. Let's say the stock tanked, and I lost $200 on the stock, but had sold the covered calls that expired for $350...well, even if I sell the stock at a $200 loss, I still profit $150 because of the covered calls.
Anyways, I actually did a successful Dell trade a month or two ago and blogged about it ("selling my first covered call") with only 100 shares (1 option) and it worked out pretty well. I'm still building up the bravery to try one of doc's other plays.
--Good post Doc.
Jim Jackson posted July 07, 2008 (03:05AM)
Thanks for the excellent post. I really like the way you explain things. There are always lots of pictures. The visuals are always very helpful.
Jim
UPod posted July 07, 2008 (03:50AM)
Doc, Thank you for taking the time to answer my questions in a blog post. Your response makes perfect sense. The graphs are also really helpful. I will keep this information front and center in my head when selling covered calls going forward.
Thanks again,
UPod
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